UNIVERSITY OF TECHNOLOGY, JAMAICA

SCHOOL OF BUSINESS ADMINISTRATION

Risk Management

TUTORIAL PAPER: #10

SUBJECT: Risk Retention/Reduction Decisions

Question 1:
Why must risk management decisions be reviewed regularly?

Question 2:
What are three steps for selecting among available risk management techniques?

Question 3:
Explain how an investment in loss control may change the optimal mix between risk retention and risk transfer
in a given situation?

Question 4:
What are the potential cash inflows to be considered in a net present value analysis of a loss control decision?

Question 5:
Explain the relationships of expected loss frequency and severity in the use of risk retention and risk transfer

Question 6:
Detail some of the difficulties in the aggregated approach to risk management.

Question 7:
The risk manager of Cagle Corporation argues that retention should be increased to allow the firm to maintain
the use of funds that otherwise would go for premiums until claims are paid. If you were either the risk
manager’s supervisor or on the board of directors, which questions would you ask?

Question 8
Suppose that Company A and Company B are identical in all respects, except that Company A has greater
financial leverage than Company B. Which firm would you expect to purchase more insurance? Explain.

Question 9
A firm earns 25% interest on its invested capital. Interest available on assets that have a low degree of risk and
are highly liquid is 10%. The firm is considering retaining a certain risk but top managers believe that a loss
reserve fund of $100,000 is necessary. Insurance against the risk is available for an annual premium of $10,000.
Based on these facts do you believe that the firm should retain the risk or do you believe that commercial
insurance should be purchased? What other information would you like to have before you make a decision?

1
Risk Management at a Television Station

Television station WMSD is located in a midwestern city of 1,750,000 people. The station is
incorporated, with the majority of the stock owned by one family. The grandfather, age 68, who founded the
station, has already begun to make gifts of the stock to other family members. His daughter, age 47, is currently
the vice president and will manage the station after her father retires or dies. The station is affiliated with one of
the three national television networks.
WMSD has 156 employees. Of these, 20 appear on the air, 7 are managers or officers, and 129 are clerical,
production, or marketing employees. The payroll for a recent year amounted to $43,550,000. WMSD’s assets
include buildings and a transmission tower valued at $47.5 million on the books, but with a replacement value
of $62 to $64 million. The station’s equipment, including cameras, videotape machines, six autos, three trucks,
a leased helicopter, and sophisticated electronic equipment and computers, has a book value of $52.6 million
and a replacement cost of $73.5 million.
In recent years, the station’s earnings after taxes were as follows: year 1, $58 million; year 2, $65 million; year
3, $40 million. The income was derived from selling commercials in the local market and from network
revenue. Interestingly, in recent years one sales representative was responsible for almost one-quarter of the
local advertising revenue. WMSD is the second-ranked station in the market and has become aggressive in the
past three years in trying to increase its market share. The station management has faced an uphill battle in
gaining ground on the number-one station, and there is concern that both stations have lost earnings to cable
television. The station’s cash flow is seasonal, with maximum receipts occurring during December. Any losses
before special events, such as sporting championships, would have a major impact on profitability.

a) Your assignment is to develop a risk management plan for WMSD.

b) You are to consider all types of loss exposures and all the risk management alternatives.
c) Give at least one example of how the risk management techniques of avoidance, assumption, loss prevention,
loss reduction, and insurance may be used.
d) Explaining why each technique mentioned part (c) above is appropriate.